02-October-2023
Natural Capsules
Sector: Pharmaceutical
CMP: ₹383 per share
Market Cap.: 353 crores
Natural Capsules began operations in 1993 by manufacturing hard capsules – which enclose the medicine to be delivered – for the pharmaceutical industry. Until FY20, the company had an unremarkable existence with stagnant sales and poor profitability. But during the last three years (FY21-FY23), the company achieved spectacular progress in growth and profitability: sales almost tripled, operating profit margin improved from 1.1 percent in FY21 to 8.94 percent in FY23, and return-on-equity improved from 1.5 percent in FY20 to 12.4 percent in FY23.
The stock had a dream run during the two years between September 2020 and September 2022 when its price appreciated from ₹60 per share to ₹600 per share; an astounding gain of 1,000 percent in two years – a 10-bagger. The price has been in a correction since hitting ₹600 per share in September 2022 and currently trades at ₹360 per share – still a 6-bagger in three years.
Business Strategy
The company incurred major capex (capital expenditure) over the last three years towards capacity expansion: the capacity increased from 7.8 BCPA in FY20 to 18 BCPA in FY23, and the still ongoing expansion will see the capacity rise further to 24 BCPA.
Through the ongoing expansion, the company intends to cater to large-volume pharma customers and increase market share. The company manufactures two kinds of capsules – hard capsules and HPMC capsules – and the ongoing capacity expansion is towards the HPMC capsule segment. The company plans to leverage the HPMC capsule expansion to serve the high-growth nutraceutical product market which presently commands higher realisation and margins than the traditional pharmaceutical industry.
In addition to the capacity expansion of its capsule manufacturing capacity, the present capex cycle also involves the company’s foray into API manufacturing through its subsidiary – Natural Biogenex Private Limited (NBPL) – set to commence in FY24. It will manufacture Prednisolone, Betamethasone, Dexamethasone, Hydrocortisone, and their respective derivative salts from its API facility.
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Competitive Position
A strong competitive position within the industry is essential to achieve superior growth and profitability. Analysing gross profit margins is a straightforward way to estimate the strength of a firm’s competitive position. Usually, companies with strong competitive positions are found to have superior gross profit margins relative to their peers. Additionally, stocks of such companies are conferred higher valuation by the market. A company can be considered to have a strong competitive position if its gross profit margin (GPM) is comparatively high and stable in recent years, preferably with a positive trend. A positive trend means the GPM is increasing gradually over the years.
For Natural Capsules, the GPM is high and stable, but the trend is negative: the GPM percentage value made a gradual decline over the past five years.
Analysis
The large capex (worth ₹175 crores) of the last three years was financed through a mix of internal accruals (16.70 percent), equity capital (31.74 percent), and debt capital (51.57 percent). Consequently, due to the reliance on equity and debt capital, there was an equity dilution of 48.8 percent in the last two years and a spike in leverage ratio from 0.11 to 0.94.
Despite a reasonably high leverage, the firm’s debt service cost is very low. This may be because since these debts were incurred only during the last two years (for capex) – full servicing of debt (interest cost) may begin only with the completion or commercialization of the capacity. Therefore, I presume that the full impact of debt servicing will be reflected in the coming years – with an adverse effect on profitability.
With a capitalisation ratio of 1.94, the firm’s business is capital-intensive: it requires large capital to sustain and grow earnings. The large capex of the last two years led to a spike in its capitalisation ratio, and its net operating assets (assets involved in operating activities) is almost double its net worth.
The working capital position, which made significant improvement in the last three years, is better: it wasn’t so three years ago with accruals being a big strain on its cash flow.
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Until FY20, Natural Capsules was a loss-making enterprise. But it turned around in FY21 with a small profit (OPM @ 1.10 percent; RoE @ 11.7 percent). However, its profit spiked significantly in FY22 (OPM @ 8.5 percent; RoE @ 18.9 percent) and FY23 (OPM @ 8.94 percent; RoE @ 17.8 percent).
It was margin expansion that contributed to the last two years’ increased profitability. The six major cost components for Natural Capsules are: 1) material costs (45.6 percent), 2) employee benefits (6.2 percent), 3) power & fuel (8.0 percent), 4) freight & forward charges (6.3 percent), contract labour charges (3.0 percent), and R&D expenses (1.4 percent).
The margin expansion of the last two years occurred primarily through reduced power & fuel costs and employee benefits expenses – which may be driven by economies of scale. Over the last five years, the employee benefits expenses’ share in revenue declined from 11.3 percent to 6.2 percent, whereas power & fuel expenses’ share declined from 12.4 percent to 8.00 percent. The share of other major costs has remained, somewhat, stable over the period.
Only earnings derived from the firm’s operations are sustainable, and that leads us to our biggest concern concerning Natural Capsules: poor operating profitability. Its return on net operating assets (RNOA) for FY23 at 6.2 percent, ruefully, is half of its estimated required return of 12.25 percent. I believe it is too risky to commit to a stock whose operating profitability does not match, at least, its required return.
After reporting excellent results for eleven consecutive quarters, the company experienced a significant earnings slowdown in the recent two quarters (March & June 2023 quarters). The trailing earnings – due to the last three years’ superior growth – have moved much farther from the median earnings. Thus, trailing earnings’ regression towards median earnings is a highly likely possibility: the recent earnings slowdown might be a precursor to that possibility.
Valuation
Natural Capsules’ stock – at the current market price of ₹383 per share – trades at a price-earnings multiple of 23.58 and price-to-book value of 2.88.
Since the return on equity (RoE) of 12.22 percent is almost equal to our estimated required return of 12.25 percent, the stock’s fair price should be closer to its book value of ₹132.85 per share – a huge discount to its CMP of ₹383 per share.
Otherwise, with RNOA at 6.2 percent, which is half of its required return, the stock should trade at half its net operating assets (NOA) = ₹258.37/2 = ₹129.20 per share – a huge discount to CMP.
As per our reverse DCF valuation, an earnings growth of 15 percent is incorporated into the current market price of ₹383 per share: a reasonable expectation.
The valuation guru Aswath Damodaran advised us to be as parsimonious as possible on valuation.
Being parsimonious, let us presume that, based on the above observations, Natural Capsules’ stock is, presently, slightly overvalued.
Strategy
I believe that committing to the stock at the current moment and price is too risky. In my opinion, the stock needs to achieve three things to become investment considerable: 1) RNOA should at least match its required return, 2) current earnings should be within the 50 percent range of its 5-year median earnings, and 3) the market price should be within 50 percent range of our estimated fair value.
AMN CAPITAL 
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